Chapter 29. Fiscal policy. Fiscal Policy

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1 Chapter 29 Fiscal Policy 1 What will you learn in this chapter? What the difference is between contractionary and expansionary fiscal policy. How fiscal policy can counteract short-run fluctuations. What challenges are associated with fiscal policies. How to calculate the fiscal multiplier. How revenue and spending determine a government budget. What the difference is between government deficit and debt. What the costs and benefits of government debt are. 2 Fiscal policy Fiscal policy refers to government decisions about the level of taxation or government spending. Fiscal policy affects the economy by influencing aggregate demand (AD). Government spending. Tax policies directly affect consumption, which impacts AD. 3 1

2 Fiscal policy Fiscal policy can be either expansionary or contractionary. Increased government spending and lower taxes have expansionary effects. Decreased government spending and higher taxes have contractionary effects. P 2 P 1 P 1 P 2 AD 2 AD 2 Y 1 Y 2 Output Expansionary fiscal policy shifts the AD curve to the right. Output increases. Prices increase. Y 2 Y 1 Output Contractionary fiscal policy shifts the AD curve to the left. Output decreases. Prices decrease. 4 Policy response to economic fluctuations Policy-makers try to use fiscal policy to smooth fluctuations in the economy. The AD/AS model illustrates how fiscal policy can counteract the effects of economic shocks. The model predicts that the economy can automatically correct itself. Lawmakers often intervene because automatic correction can be a painful and slow process. 5 Expansionary policy responses Expansionary policy can counteract decreases in AD. Initial market response to fall in AD Expansionary fiscal policy restores some AD P 1 P 3 P 2 P2 AD 3 Y2 AD 2 Y 1 Output The government can spend more or tax less. Often called Keynesian economic policy. The expansionary policy increases aggregate demand. Output and price levels increase. Y2 Y 3 AD2 Output 6 2

3 Contractionary policy responses Positive economic shocks may cause the economy to expand too rapidly. Contractionary policy can counteract increases in AD. Economy overheats from too much AD Contractionary fiscal policy lowers prices and output P 2 P 1 AD 2 P2 P3 AD 2 AD 3 Y 1 Y 2 Output The government can spend less or tax more. The contractionary policy decreases aggregate demand. Output and price levels decrease. Y 3 Y 2 Output 7 Time lags Why should any government wait for the economy to correct itself when it can do the work much more quickly? Fiscal policies are often educated guesses. Time lags between when policies are chosen and when they are implemented often cause fiscal policy to be ineffective or even harmful: 1. Information lag: Understanding the current economy. 2. Formulation lag: Deciding on and passing legislation. 3. Implementation lag: Time to affect the economy. 8 Policy tools: discretionary and automatic Automatic stabilizers are taxes and government spending that affect fiscal policy without specific action from policy-makers. Taxes work as automatic stabilizers because the income tax system is progressive. As earnings rise, higher tax rates apply. This puts a check on overall spending. Some types of government spending work as automatic stabilizers. Unemployment insurance benefits and welfare programs have eligibility criteria based on income or unemployment status. 9 3

4 Policy tools: discretionary and automatic Policy-makers can also use discretionary fiscal policy, which refers to adjusting tax rates in response to economic conditions. Information, formulation, and implementation lags can reduce the effectiveness of such policy. Discretionary policy may be used when automatic stabilizers are unsuccessful in correcting the economy. 10 Limits of fiscal policy: The money must come from somewhere Politicians often cut taxes in response to recessions. Tax cuts aren t free because the government must find a way to make up for lost tax revenue. Ricardian equivalence predicts that if there are tax cuts but no decrease in spending, people will not change their behavior. People realize that the government will have to borrow money and at some point taxes will increase. 11 The multiplier model Changes in tax rates and government spending have different effects on the economy. Economists use a multiplier that measures the effect of government spending or tax cuts on national income. The multiplier effect is the increase in consumer spending that occurs when spending by one person causes others to spend more too. This amplifies the impact of the initial government policy on the economy. 12 4

5 The multiplier model For example, consider what happens when someone hires a builder to construct a deck for $5,000. This decision adds $5,000 to national GDP. The builder may take his family on a $3,000 vacation that he couldn t have afforded before he built your deck. This decision adds $3,000 to national GDP. The decision to build a deck adds $8,000 to GDP, more than the original amount of the deck. This is the multiplier effect. 13 Deriving the multiplier To determine how much more GDP increases, the multiplier uses the proportion of income people spend. Consumption is based on the amount of income left after paying taxes. People usually consume part of their income and save the rest. The amount consumption increases when after-tax income increases by $1 is called the marginal propensity to consume (MPC). The MPC is a number between 0 and 1. It equals the fraction of an additional dollar that is spent when an individual receives an additional dollar of income. For example, a MPC of 0.8 means that 80% of an additional dollar of income is spent and 20% is saved. 14 Active Learning: Deriving the MPC Consider the following situations where there is an increase in income that leads to an increase in consumption expenditures. Calculate the marginal propensity to consume (MPC). Situation Increase in Income ($) Increase in Consumption Expenditures ($) Marginal Propensity to Consume (MPC) A 1, B C

6 Multiplier effect of government spending The government-spending multiplier is the amount that GDP increases when government spending increases by $1. Government spending multiplier = 1 1 MPC A smaller MPC results in a smaller governmentspending multiplier. A larger MPC results in a larger governmentspending multiplier. 16 Active Learning: Government-multiplier effect Consider a situation where the marginal propensity to consume is 0.6. Calculate the government-spending multiplier. Use this to determine how much GDP will increase if the government spends $10 million on federal highway repairs. 17 Multiplier effect of government transfers and taxes The taxation multiplier is the amount that GDP decreases by when taxes increase by $1. Taxation multiplier = MPC 1 MPC The multiplier effect of tax cuts is smaller than the effect of government spending. Tax cuts boost GDP indirectly through an effect on consumption. 18 6

7 Active Learning: Taxation multiplier effect Consider a situation where the marginal propensity to consume is 0.6. Calculate the taxation multiplier. Use this to determine how much GDP will increase if there are $10 million in tax cuts. 19 The government spending and taxation multipliers The impact of tax cuts and government spending varies by the MPC. Marginal Government- A $500 million Taxation multiplier A $500 million propensity to spending multiplier stimulus would MPC/(1 MPC) tax cut would Consume (MPC) 1/(1 MPC) increase GDP by: increase GDP by: $625 million 0.25 $125 million $835 million 0.67 $335 million $1.25 billion 1.50 $750 million $2.50 billion 4.00 $ 2 billion Note that for the same MPC, the government spending multiplier is higher than the taxation multiplier. The difference is greater as the MPC increases. 20 The government budget The government may want to influence the economy by changing the amount it spends or taxes. In practice, this may require the government going into debt. Governments budgets contain tax revenues as their source of income and government purchases and transfer payments as expenditures. Transfer payments are payments from the government to individuals for programs that don t involve a purchase of goods or services. 21 7

8 The government may budget expenditures greater than income by issuing debt. The budget deficit is the amount of money a government spends beyond its revenue. The budget surplus is the amount of revenue a government brings in beyond what it spends. The government budget Billions of constant 2010 dollars 1,600 1,400 1,200 1, U.S. government deficit since 1940 Billions of 2010 dollars Percent of GDP Percent of GDP Since the 1940s, the U.S. has consistently maintained a budget deficit The public debt Public debt is the total amount of money that a government owes at a point in time. Public debt is the cumulative sum of deficits and surpluses. Billions of 2010 U.S. dollars 15,000 12,000 U.S. government debt since 1940 Total debt in billions of 2010 dollars Percent of GDP Percent of GDP , , , U.S. government debt has risen rapidly in the last decade, with larger budget deficits. 23 The public debt Almost every country in the world has some debt. Debt in various OECD countries, 2010 Country (rank) Japan (1) Greece (2) Italy (3) 109 France (10) United States (11) Ireland (12) Korea (24) Public debt as a percent of GDP There is a wide discrepancy in the amount of debt owed among countries. 24 8

9 Is government debt good or bad? Most economists believe that some debt is necessary to have a smoothly functioning government. What are the costs and benefits? Benefits of government debt It allows the government to be flexible when something unexpected happens. Government debt can pay for investments that lead to economic growth and prosperity. Costs of government debt The direct cost associated with government debt is the interest on borrowing. There are indirect costs associated with government debt distorting credit markets. The government must consider who bears the burden of the debt. People today benefit when the government borrows, but future generations will have to repay the loans. 25 Summary The level of taxation and government spending is called fiscal policy. Expansionary fiscal policy can be used during a recession to increase AD. Contractionary fiscal policy can be used during a boom to decrease AD. The government might want to change fiscal policies to counteract economic fluctuations. 26 Summary The two main challenges the government faces when implementing fiscal policy are time lags and Ricardian equivalence. The government-spending multiplier measures how much output increases when government spending increases. The taxation multiplier measures how much output increases when taxation falls. The government-spending multiplier is larger than the taxation multiplier. 27 9

10 Summary The government budget includes all of the revenue it collects in taxes and the money it spends on government programs. There is a deficit when the government spends more than it collects. There is a surplus when the government collects more than it spends. The public debt is the total amount of money that the government has borrowed over time